Ask the expert: Should I pay into an ISA, pension or overpay my mortgage?
Fidelity personal finance specialist Marianna Hunt helps a saver decide where to place their capital as interest rates fall.
Q: In light of current interest rate expectations, is it better to pay down my mortgage, pay into my pension or invest in an ISA? I have a £350,000 property with a £200,000 mortgage at 4 per cent, £100,000 in a pension and £50,000 in a stocks and shares ISA.
A: This is a very important question and one that I’m sure many others will be asking themselves. When mortgage rates were at 1-2 per cent, few people would have spent sleepless nights over this. But now, with rates much higher, the situation is quite different.
If I could wave a magic wand and give you a simple answer, I would. But, unfortunately, the reality is much more complicated.
Experts generally suggest that, if you’re investing sensibly for the long-term in global stocks, you could expect a return of around 5 per cent a year on average (after fees). Whereas, in your case, overpaying your mortgage guarantees you a 4 per cent return on your cash.
The first thing to consider is your risk tolerance. If you’re the kind of person who prioritises security over anything else and the idea of stock market volatility would make you lose sleep, then paying down debt at 4 per cent could well be preferable to hoping for a 5 per cent return from investing.
However, it’s important to remember that over time, the difference between the two could become significant.
If you have £200,000 to repay on your mortgage at 4 per cent interest over, say, the next 20 years, overpaying the mortgage by just £100 a month could mean you clear the debt two years earlier than expected.
If you then invested the amount you would have spent on your mortgage plus the extra £100 after that, you would end up with an investment pot of around £37,000 at the end of the 20-year period.
However, if you’d spent the 20 years investing your £100 a month instead of overpaying the mortgage, you’d still have cleared the debt and ended up with an investment pot worth £41,000. Both scenarios assume you’re achieving investment returns of 5 per cent a year after fees.
In both option one and option two, you’re putting in the same amount of money, but with option two (investing £100 a month), theoretically, you could end up with a bigger investment pot at the end. The difference isn’t huge, but you’d have also spent 20 years teaching yourself how to invest, a valuable skill for life.
Caution with overpaying mortgage
It’s worth bearing in mind that interest rates are likely to fall over the next 12 months, though we don’t know by how much or how quickly. Overpaying your mortgage today will be less valuable if rates were to fall significantly by the time you come to renew your mortgage in, say, a year or two.
When you overpay your mortgage, it can be very tricky to get that money out again.
If you overpay your mortgage, then fall ill, and find yourself unable to keep up with your mortgage payments, that could be very dangerous.
Therefore, homeowners should only overpay their mortgage if they have sufficient emergency funds and insurance (including critical illness cover) in place.
What’s more, if you use all your surplus income to pay off your mortgage, you will end up with just one asset at the end. That asset may go up in value, but equally, it may not.
Whereas, if you continue making your mortgage payments and put excess savings into a fund investing in global stock markets, you will have a much more diversified portfolio of assets.
This doesn’t mean that overpaying your mortgage is necessarily the wrong answer. But these are all factors you should consider.
If you do decide to invest the money, the decision of whether to put it into an ISA or a pension will depend on your goal. If you’re saving for retirement, then the pension is likely to be a better option thanks to the tax relief you get. Remember, you can’t access that pension money until age 55 (rising to 57). If your goal is to use the money before 57, then the ISA would likely be a better option.
Individual tax circumstances
Ultimately, though, which of these three routes is best will depend on your individual circumstances.
If you’re a higher or additional rate taxpayer, it may be much better to pay more into your pension. A higher-rate taxpayer could use salary sacrifice to put £100 of their pre-tax salary into their pension. Because that £100 would otherwise have been taxed at 40% income tax and 2% National Insurance, the pension contribution will only cost £58 of your take-home pay.
Equally, if your employer matches your contributions, this can make paying into a pension more attractive.
If you put £100 into your pension (costing you only £58 if done via salary sacrifice) and your employer matches that by adding another £100, you’ve essentially turned £58 take-home pay into £200 in your pension, and that’s even before considering any investment returns you might make.
You should check whether you are approaching any income cliff edges at which you lose valuable allowances.
For example, once you earn more than £80,000, you lose any child benefit allowance and, from £100,000, you start to lose your personal income tax allowance. If this is the case, it may make even more sense to use salary sacrifice to pay into a pension and try to bring your salary below these thresholds.
There are changes coming in that will impact salary sacrifice contributions to pensions, however, they won’t take effect until 2029.
Please remember that this is not financial advice. Every person’s situation is unique, and, in many cases, it would be valuable to speak to a qualified financial adviser.
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